When $3 tril­lion just isn’t enough

The Pak Banker - - OPINION - Christo­pher Bald­ing

MOST con­ver­sa­tions about the Chi­nese econ­omy come with a re­as­sur­ing caveat: With $3.3 tril­lion in for­eign-ex­change re­serves at their dis­posal, Chi­nese lead­ers can bring al­most un­lim­ited fire­power to bear to de­fend the yuan, re­cap­i­tal­ize state banks or spread cheap loans abroad to win in­flu­ence. Such con­fi­dence, how­ever, may be mis­placed.

Those tril­lions of dol­lars add up to a lot less than many peo­ple seem to imag­ine. The to­tal, given out by the Peo­ple's Bank of China, is con­sid­ered rel­a­tively ac­cu­rate. But that's not the whole story. Ac­cord­ing to nu­mer­ous es­ti­mates, close to a third of China's re­serves are held in illiq­uid as­sets -- for in­stance, longterm in­vest­ments in in­fra­struc­ture projects that are part of the so-called New Silk Road. That im­plies that more than a tril­lion dol­lars could only be tapped in a longer time hori­zon of at least one year. Even if the true num­ber is half as much, that would re­duce the range of use­able FX re­serves to around $2.8 tril­lion.

Add to this the ques­tion of how much for­eign ex­change China needs to hold in or­der to be pru­dent. The IMF has de­vel­oped a sug­gested frame­work based upon re­search into pre­vi­ous cur­rency crises. Ac­cord­ing to this for­mula, coun­tries should main­tain re­serves equiv­a­lent to the sum of 30 per­cent of their short­term for­eign-de­nom­i­nated debt, 15 per­cent of other port­fo­lio li­a­bil­i­ties, 10 per­cent of the M2 comes from M2, which in China to­tals ap­prox­i­mately $21 tril­lion. Cur­rently, even China's seem­ingly huge re­serves amount only to 15 per­cent of M2 money sup­ply, the low­est pro­por­tion since 2008; even if that share were low­ered to 10 per­cent, China would still need $2.1 tril­lion to cover it. Cov­er­ing short-term for­eign debt, port­fo­lio li­a­bil­i­ties and yearly ex­ports would add an­other $900 bil­lion.

Right now, Chi­nese FX re­serves stand at about 110 per­cent of this rec­om­mended num­ber. Ex­clud­ing the illiq­uid re­serves, though, China's hold­ing only 93 per­cent of the to­tal. (In fact, the IMF sug­gests coun­tries main­tain re­serves as high as 150 per­cent of the to­tal num­ber, which would make China's short­fall even more dra­matic.)

Fur­ther­more, of­fi­cial Chi­nese FX re­serves held by the PBOC are fall­ing fast, de­clin­ing $100 bil­lion per month since Oc­to­ber. With Chi­nese cit­i­zens and firms rac­ing to get their money out of the coun­try -- spurring an es­ti­mated $1 tril­lion in cap­i­tal out­flows in 2015 - - the govern­ment has had to de­ploy re­serves buy­ing yuan, to prop up the cur­rency's value.

There's lit­tle in­di­ca­tion that this trend is about to be re­versed. In­deed, the cen­tral bank is burn­ing through more and more of its re­serves ev­ery month and when worry sets in, num­bers tend to gain speed.

De­pend­ing on ex­actly how fast cap­i­tal leaves China, Bei­jing could be look­ing at a wor­ry­ingly low level of re­serves as soon as July. At cur­rent rates, China will drop be­neath the rec­om­mended amount of $3 tril­lion at the end of the first quar­ter even if in­clud­ing all illiq­uid as­sets; ex­clud­ing them, China could have fewer than $2 tril­lion in us­able re­serves by sum­mer. By the end of the year, the govern­ment could face a sit­u­a­tion where the only tools left to pre­vent the cur­rency's slide could be hard cap­i­tal con­trols that pre­vent money from leav­ing the coun­try -- an em­bar­rass­ing state of affairs for the world's se­cond-largest econ­omy.

How should Chi­nese pol­i­cy­mak­ers re­spond? First, they have to ac­cept that the fi­nan­cial laws of physics ap­ply to China. The PBOC may have a good case to lower in­ter­est rates. But with loan de­mand down, fears ris­ing over equity mar­kets, and a huge over­hang of sur­plus ca­pac­ity, fur­ther mon­e­tary eas­ing is sure to prompt ad­di­tional out­flows as in­vestors seek higher re­turns else­where. That means con­tin­ued down­ward pres­sure on the yuan, forc­ing the PBOC to spend bil­lions more to buy up the cur­rency. By seek­ing both looser mon­e­tary pol­icy and a strong yuan, the cen­tral bank is pur­su­ing a set of con­tra­dic­tory poli­cies that can't suc­ceed. The PBOC needs in­stead to chart a course to­ward ei­ther float­ing the yuan or im­pos­ing cap­i­tal con­trols. There sim­ply are no other al­ter­na­tives.

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